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The Debt Ceiling – beyond the media hysteria

July 29, 2011

The media loves politics, especially presidential election politics, so the frenzy about the debt ceiling is not surprising. But, beyond the politics (which I do not claim to understand better than anybody else), what are the real economic issues associated with failing to raise the debt ceiling? Is this really a crisis? A few observations that I feel comfortable with:

1. Almost certainly, the rating of US government bonds will go down. How much of an interest rate rise that results will depend on the degree to which there is panic among investors. I think the rise will be slight – the US government remains the safest investment around and I think we will see funds flood into Treasuries as soon as the interest rate rises. Failure to reach political agreement will send a signal to people that the US government is even more dysfunctional than they thought, and this raises the risk of loaning it money.

2. The credit rating itself is of little influence – does anybody really believe that the ratings agencies have any special insight about the creditworthiness of the Federal government?

3. Much is made of the fact that many other interest rates are tied to T bills. This is not a law – it is a practice that reflects the risk of various loans relative to T bills. If you really believe that T bills have become a riskier investment, then the risk premiums for these other loans should fall – and the link to T bills should be broken. On the other hand, if the underlying risk of default on T bills is not really any higher, then all interest rates will rise when the credit rating is reduced. Since T bills are safer than these other investments, and since T bills will pay higher returns, creditors will want higher returns from these other relatively riskier investments. I think this is the most likely scenario (I ignore the practical complications that some investments require AAA ratings and these will have to move out of T bills if their rating declines).

4. The effects of higher interest rates upon the economy will be negative, but should be relatively modest. UNLESS – consumers and businesses go into a tailspin and the markets react with panic. Then, all bets are off – except that it becomes far more likely that Congress will get its act together and raise the ceiling.

5. Higher interest rates on government bonds will have a number of effects. Holders of these bonds will see higher returns (most of the debt is held domestically, but a fair amount is held by foreign entities). The Federal deficit will worsen as interest payments rise.

I don’t mean to suggest that the stalemate and debt crisis are unimportant. Long term, the government needs to reduce the deficits. Politically, there is little reason to trust that Washington can or will do what it needs to – hence, the resistance of many rational people to just raising the ceiling and let things proceed as usual. Balanced budget amendments, dramatic changes in entitlement programs, and similar hysterics serve political ends. They have little economic merit, but politics is not about economic rationality.